Capital Asset Pricing Model, and Beta

(1) The Capital Asset Pricing Model (CAPM) is a linear model that can be used to estimate a company's cost of equity and determine a stock's required rate of return. The required rate of return is one input into the Dividend Discount Model, a model used to determine the value of a company's common stock. There are a several varieties of the Dividend Discount Model including the zero growth model, the constant growth model, and the differential growth model. An analyst needs to use his or her best judgment to determine which model variety should be used to value a company's common stock. For example, if the analysts forecasts that the company's dividends will grow at a fixed rate of 5% per year forever, then the constant growth model should be used. If, on the other hand, the analyst forecasts that the company's dividends will grow at a 15% growth rate for the next three years and then growth at a constant rate of 7% per year, then the differential growth model should be used. As you can see, there's a lot of estimation involved in applying the Dividend Discount Model. Because of this situation, it's useful to conduct a sensitivity analysis.

Penman, S.H. (1997, November 5). A synthesis of equity valuation techniques and the terminal value calculation for the dividend discount model. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=38720
Womack, K.L, & Zhang, Y. (2003, December 19). Understanding risk and return, the capm, and the fama-french three-factor model. Retrieved from http://papers.ssrn.com/so13/papers.cfm?abstract_id=481881

Beta is one of the inputs into the CAPM. How's a stock's beta determined? Is beta a good measure of risk? Why or why not?

(2) A corporation's cost of debt is typically lower than a corporation's cost of equity. A reason for this is because corporations get a tax deduction from using debt financing. Therefore, assuming a positive tax rate, a firm's after-tax cost of debt financing is lower than a firm's before-tax cost of debt financing. The cost of debt financing is equal to the yield to maturity on the company's bonds. The cost of equity financing can be determined with the Capital Asset Pricing Model or through the dividend yield plus growth rate approach. Beta, a measure of systematic risk, is an input in the CAPM. The higher the stock's beta, as is usually the case with technology companies, the higher the cost of equity financing. Even though the cost of debt financing is lower than the cost of equity financing, it doesn't mean that the company should have an excessive amount of debt in its capital structure, particularly for cyclical companies. The company pays interest to bondholders; during a recession, the company may not generate enough money to pay the bondholders. This may cause the company to eventually file for bankruptcy. On the other hand, there's no requirement to pay dividends to common stockholders.

(3) There are three main types of acquisitions: an acquisition of assets, an acquisition of stock, and a consolidation or merger. With an acquisition of assets, a company acquires another company by purchasing all of the company's assets. With an acquisition of stock, the company's voting stock is bought in exchange for shares of stock, cash, etc. A merger occurs when one company is absorbed by another company. A consolidation is similar to a merger except that in a consolidation a completely new company emerges. An acquisition is characterized as a vertical acquisition, a horizontal acquisition, or a conglomerate acquisition. A vertical acquisition occurs when a company acquires a company that's from a different part of the production process. A horizontal acquisition occurs when a company acquires a competitor. A conglomerate acquisition occurs when a company acquires a company in a totally different industry. A Net Present Value (NPV) calculation is typically employed by a company to determine if an acquisition should move forward.